The Inevitable Demise of the Euro

In a free market, the value of any currency is determined by the demand for that currency for the purposes of trade. If an importer in country A wishes to buy goods from an exporter in country B and the price of those goods is denominated in the currency of country B, then the importer has to buy units of that currency in order to pay for the said goods, simultaneously selling units of his own country’s currency in order to do so. This latter transaction, along with thousands of other transactions just like it, is what then determines the price of the currencies involved. For if more people want to buy goods from country B than country A, then the demand for currency B, along with its price, will rise, while the demand for currency A, along with its price will fall. 

It is for this reason also that, in a free market, trade tends towards equilibrium. For if there is a significant and persistent imbalance in trade, then the currencies of the net importers will continue to decline against the currencies of the net exporters, such that the goods of the net exporters become more and more expensive. This results in the net exporters selling less and the price of their currencies consequently falling until some kind of equilibrium is reached.

This doesn’t mean, of course, that significant and persistent trade imbalances cannot exist. Rich countries with large stores of accumulated wealth – otherwise known as capital – can maintain trade deficits for decades without damaging their currencies, especially if, like the USA, their currency has a reserve status and is used for international trade in which the issuing country is not a party. However, all such trade deficits represent capital out-flows and eventually even the richest countries will become impoverished by such capital loss, such that the tendency towards equilibrium is restored.

Other than by countries borrowing or printing money in order to continue importing goods they can no longer afford – both of which practices, in themselves, tend towards instability and currency devaluation – there are only two ways to prevent or forestall this tendency towards balanced trade. The first is through currency manipulation, where the currency of an exporter is held at an artificially low value. In ‘The End of an Era (Part II)’, which you can find here, I described how China, with the tacit agreement of the United States, kept its currency – the renminbi or yuan – pegged to the dollar at between 30 and 40% below its true value for more than twenty-five years. This allowed it to build up a massive trade surplus in manufactured goods with the rest of world, laying waste to large parts of manufacturing industry not just in America but throughout the West, while at the same time accumulating huge capital reserves. 

I said in ‘The End of an Era (Part II)’ that, one day, this would be seen as one of the worst mistakes in post-war history. And I still hold to this view. However, there is another mistake that gets fairly close to it in terms of the damage the West, and Europe in particular, has managed to inflict upon itself: a mistake which relates to the second way in which the tendency towards balanced trade can be thwarted. This is by means of the creation of a monetary or currency union between countries with very differently performing economies, especially with respect to productivity. For if one or more  countries in such a union has a significantly higher rate of productivity than the others, it will either be able to produce goods more cheaply than its neighbours, or of a higher quality at the same price, thus giving it a distinct trading advantage. 

And, indeed, this is what we find in the Eurozone, where Germany, in particular, runs a significant trade surplus with nearly all the other members, who, due to the simple fact that they all share the same currency, are unable to counter this imbalance via the usual mechanism of currency devaluation. Worse still, because goods flow one way and capital flows the other, there has been an inexorable build-up of capital in Germany where it has inevitably been invested in further improving productivity, thereby widening the productivity and trade gap even further.

Nor is the advantage Germany has gained from this confined to the Eurozone. For the value of the euro on international currency markets is determined not just by the volume of demand for it to buy German goods, but by the volume of demand for it to buy goods from the Eurozone in its totally, which, on average, pulls the price of the euro down. As a result, the price of German goods sold to the rest of the world is significantly lower than would be the case if they were still denominated in Deutschemarks, allowing Germany to establish significant trade surpluses with nearly all other western countries, including both the UK and the US, thereby creating even more capital inflows from outside the Eurozone to invest in even greater productivity. And so it goes on.

The real casualties in all this, however, are the other members of the Eurozone, especially those in southern Europe, usually referred to as the Club Med group, whose comparative disadvantage can clearly be seen from the imbalances which, over years, have gradually built up in the Eurozone’s international settlement system, known as Target2: a distributed transaction processing platform managed by the ECB to which all the EU’s national central banks (NCBs) belong, along with all of their affiliated commercial banks, the purpose of which is the clearance of all international transactions denominated in euros. 

To understand how it works – or, at least, how it is supposed to work – imagine, if you will, a Mercedes car dealership in Italy which places an order for €10 million worth of new cars from Daimler-Benz in Germany. Daimler-Benz duly fulfils the order and sends the dealership an invoice, which the dealership duly instructs it’s bank, UniCredit, to pay. UniCredit then transfers the funds from the dealership account to the UniCredit Target2 account at the Italian NCB, Banca d’Italia, with further instructions as to where it is to be sent. Banca d’Italia then sends the money to the Deutsche Bundesbank, the German NCB, which places it in the Target2 account of Commerzbank, Germany’s second largest commercial bank, which finally transfers it to the current account of Daimler-Benz.

Naturally, this is something of an oversimplification of a process which undergoes wholesale aggregation and ‘netting’ out at each step of the way, so that only the net amounts owing are ever transferred between NCBs. At some point, however – though I don’t know when and I don’t know who authorised it – even the net amounts stopped crossing certain borders, the electronic border between Italy and Germany being a case in point.

Daimler-Benz, of course, still gets paid. Commerzbank – if it is Commerzbank with whom  Daimler-Benz actually banks – still credits the corporation’s account with the €10 million. But Commerzbank, itself, does not get any money from the Bundesbank. Instead, it receives from them an IOU, which, coming from a central bank, is probably as good as money. In fact, you might ask what else ‘money’ actually is. In reality, however, what happens is that Commerzbank places a debt of €10 million owed to it by the Bundesbank on the asset side of its balance sheet, while the Bundesbank places a debt of €10 million owed to Commerzbank on the liabilities side of its ledger.

Similarly, no money is actually transferred from Banca d’Italia to the Bundesbank. Instead, the Bundesbank places a debt of €10 million owed by Banca d’Italia on the asset side of its balance sheet, while Banca d’Italia places a debt of €10 million owed to the Bundesbank on the liabilities side of its balance sheet. Finally, to complete the transaction, UniCredit removes €10 million from the account of the Italian car dealership – so that the latter does actually pay the money – but UniCredit does not actually transfer the money to Banca d’Italia. Instead, it places a debt of €10 million owed to Banca d’Italia on the liabilities side of its balance sheet, while Banca d’Italia places a debt of €10 million owed to it by UniCredit on the asset side of its ledger.

Thus, while no money actually changes hands, the whole system is in balance. The result, however, is that after years of unsettled transactions building up within the Target2 system, as of 31^st October 2018, half of the Eurozone owed the other half over €1 trillion as shown in Table 1, with Italy being the biggest debtor at €489.5 billion, and Germany the biggest creditor at €927.6 billion.

Debtor NCBs	€ billions		Creditor NCBs	€ billions
Belgium	5.3		Germany	927.6
Estonia	0.2		Ireland	11.8
Greece	29.3		Cyprus	8.4
Spain	397.5		Luxembourg	223.7
France	25.8		Malta	3.6
Italy	489.5		Netherlands	91.7
Latvia	7.3		Finland	49.6
Lithuania	4.8		Slovenia	0.2
Austria	47.0		Slovakia	10.5
Portugal	78.7		Non-Eurozone	4.2
Totals	1,085.4			1,331.3
Imbalance shown as ‘ECB’	245.7

Table 1: Target2 Debtors and Creditors

Ignoring the question as to how the ECB can appear as a debtor in this system – a question to which I have not been able to find an answer despite lengthy searches – the real question one has to ask is how, given that Target2 is supposed to be a transaction processing and settlement system, these unsettled accounts could have been allowed to build up to such an extent. And why?

The answer, however, is not straightforward and is the result of a number of interconnected problems in the overall Eurozone banking system.

The first of these is the problem of ultra-low interest rates, which makes it very difficult for any bank to make much of a profit, especially on their primary fall-back or fill-in business of short-term interbank lending, through which otherwise uninvested or unlent deposits in customers’ current accounts – on which no interest is usually paid – would previously have been lent to other banks at an annualised overnight rate of somewhere between 3% and 4%, thereby generating a steady and almost risk-free revenue stream which more or less covered all the bank’s administrative costs. With the ECB’s marginal lending rate now set at 0.25%, however – down from more than 5% before the financial crash – interbank lending rates have more or less collapsed, with the result that banks now have to resort to more higher risk lending just to break even.

Yes, they try to avoid this as much as possible and make up for the deficit by charging customers for services that were previously free. But this hardly makes up for the reduction in the safe, regular income which interbank lending used to provide, especially as, being within the Eurozone, there are now other services on which they used to charge commission but which have now gone into steep decline.  This especially applies to foreign exchange services which, for most European banks, have been cut by more than half since the introduction of the single currency. 

To compound this, ever since the crash of 2008, all banks have come under ever more stringent regulations as to how much of their own capital they must hold. This varies between 7% and 10.5% of their total risk-weighted assets depending on their size and the systemic risk they therefore pose to the rest of the financial system. As ‘own capital’ is a combination of shareholder equity and retained profits, their general lack of profitability therefore gives them two further problems. Firstly, it makes it very difficult for them to build up their capital reserves organically through year on year retentions, especially if they want to provide an acceptable dividend to their shareholders. Weak profitability and a poor return on investment then also make it difficult for them to raise additional capital on equity markets.

This then leads to another, even more serious problem. For given their capital requirements and the difficulties they have in replacing capital, the one thing no bank can afford to do is make a loss, or admit it if they do. Combined with more risky lending practices, this has therefore led to a slow but inexorable accumulation of Non-Performing Loans (NPLs), or bad debts on the balance sheets of most Eurozone banks.

There are, of course, rules against this. In fact, they are quite detailed. Any loan on which a payment has been overdue for more than 90 days, for instance, is supposed to be written down to 70% of its nominal value. Any loan which cannot be recovered without legal action should be written down to 40%. And any loan that is deemed unrecoverable is supposed to be written off completely. The problem is that it is the banks themselves that make this assessment. And so they are naturally reluctant to write off any loan where there is any hope at all of recovery, no matter how slight, especially if such a write-off were to detrimentally affect their capital position.

This problem is further exacerbated by the fact that the NCBs, who are supposed to police this area of banking operations, are not inclined to be overly stringent when it comes to the enforcement of the rules. This is because, in addition to their general capital requirements, banks are further required to hold at least 5% own capital against their loan book. That is to say that, whatever other investments they may make, they can only lend twenty times their capital reserves to their commercial customers. This means that if they are forced to write off €1 million worth of NPLs, and consequently find their capital reserves reduced by the same amount, they are required by law to reduce their loan book by €20 million, calling in €20 million worth of good loans, which, if the borrowers cannot instantly return the money, may well turn into bad loans as a result. Indeed, it could well put many firms out of business and have a devastating effect upon the economy. Which is why the NCBs are not particularly exacting when it comes to enforcing the write-off rules for NPLs.

The result is that NPLs have accumulated on the balance sheet of Eurozone banks to the point at which the problem has now probably become insoluble. As a percentage of total assets, what proportion of Eurozone loans are NPLs? Only the banks, themselves, know that for sure. And they’re not telling anyone. Most estimates, however, place the figure above 20%. As even the largest banks are only required to hold capital to the value of 10.5% of their assets, this would therefore make all Eurozone banks insolvent if the NPLs were evenly distributed. Fortunately, some Eurozone countries’ banks have more NPLs than others, with Italy, Spain and Portugal being the worst offenders.

Why this should be the case is hard to say. Some people attribute it to the boom in the building industry before the financial crash, when, all around the Mediterranean, there was a massive amount of investment in holiday villas and time-share apartments, many of which still remain empty or even unfinished. However, looking for specific reasons for the preponderance of NPLs in certain countries is unnecessary. For, statistically, there will always be more business failures and hence more NPLs in poorly performing economies than in more successful ones. And this simply brings us back once again to the imbalance of trade within the Eurozone. 

What this also means, however, is that the state of the banks in some of these countries is truly shocking. Take UniCredit, for example. It tried to solve its NPL problem by creating what is generally known as a ‘bad bank’, a special purpose vehicle (SPV) into which it was going to place all its NPLs in return for bonds issued by the SPV and backed by the NPLs themselves. When the ratings agency, Moody’s, examined the NPLs to assess their value, however, it decided that they were so bad that the bonds issued by the SPV would be below ‘investment’ grade, such that, as a bank, UniCredit could not invest in them or take them in exchange for the NPLs, with the result that the plan fell through. Ironic or what?

What makes this general situation even worse, however, is the fact that the people who count, the customers of these insolvent banks, know that they are insolvent and have acted accordingly. For although the EU has a bank deposit guarantee scheme through which the national governments guarantee deposits up to €100,000, savers in Italy, Spain and Portugal etc. do not believe that their governments would have the resources to honour this commitment should there be a general banking failure.

And they are quite right. Italy, for instance, has a debt to GDP ratio of 132%, the second highest in Europe after Greece, and is only able to continue borrowing money at affordable interest rates due to the ECB’s Quantitative Easing programme, through which Banca d’Italia buys up all the bonds issued by the Italian treasury after they have first been bought by Italian banks. If there were a general banking failure, however, this system would itself fail, in that all of the Italian banks would have gone bust, leaving the Italian government with no one from whom they could borrow money in order to compensate depositors. 

This has therefore led to huge amount of ‘capital flight’, especially from Italy, which, somewhat inconveniently, happens to border Switzerland. What this also means, therefore, is that, with all of the Italian banks’ own capital tied up in NPLs – none of which can therefore be recycled – and with most of their depositors’ savings having been withdrawn to safer havens, most Italian banks would have now been left with almost no money at all to lend to new borrowers. Indeed, under this scenario, not only would the entire Italian banking system have already collapsed, but the whole Italian economy would have been sent back into a pre-banking era. And the only thing that has prevented this from happening are the unsettled balances within the Target2 system. For what these liabilities effectively represent are unofficial loans from Banca d’Italia to Italian banks which have more or less replaced the withdrawn deposits of their customers, thereby maintaining their overall liquidity. 

Not, of course, that this has ever been admitted to the public. Nor has it ever been talked about in the mainstream media. Yet everyone who has anything to do with Eurozone economics and finance must surely know this. Indeed, it is something which the whole Eurozone banking system has to be colluding in. Otherwise, German banks would be demanding payment of what they are owed from the Bundesbank. And the Bundesbank would accordingly be demanding payment of what it is owed from each of its counterparty NCBs across Europe. And these NCBs would then be demanding payment from their own commercial banks. Except, of course, they know that their commercial banks do not have the money to make these payments and that any demand on them do so would bring down the entire Eurozone banking system. For it is not ultimately Banc d’Italia that lent €10 million to UniCredit in my little example above; it was Commerzbank. In fact, as shown in Table 1, German banks have lent a total of €927.6 billion to counterparty debtor banks across the continent: €927.6 billion which can never be repaid and which therefore constitutes the largest portfolio of NPLs in the Eurozone. And it is thus German banks which are now the real threat to the system.

Even though it is little reported outside of the financial pages of a few quality newspapers, most people will be aware of the problems which Deutschebank, for example, has suffered over the last few years and which would appear to be coming to a head. Last quarter, it lost over €3.6 billion and recently announced 18,000 redundancies in an attempt to return to profitability. Of course, not all of its problems are due to the billions of euros it has lent to other banks at zero interest rate through the Target2 system and which it has little chance of ever getting back. It is mired in mismanagement and riddled with corruption. However, lending so much money on an indefinite basis without return certainly hasn’t helped its position. 

So what is the solution? Well, it’s quite simple. The banks of the countries that are debtors within the Target2 system need to be recapitalised. They can then write off the NPLs on their balance sheets and pay off their debts. The trouble is, of course, that this would require an investment of around €1 trillion. And, quite frankly, these banks, with their poor profitability, dodgy accounting and other liabilities which they have almost certainly hidden, simply aren’t worth that much. Indeed, it is very unlikely that any commercial enterprise would even consider taking over and recapitalising any of these ‘zombie’ banks. Otherwise, they’d have already done so, not just with the blessing of the governments involved but with their eternal gratitude.

So what about the governments, themselves? What if they were to nationalise these banks and, themselves, invest in them? After all, it is the obvious solution. Apart from the fact that it is against EU rules, however, the problem with this is that it would very probably be as destabilising to the euro as the collapse of the banking system itself. 

To see this more clearly, consider again the situation of the Italian banks. They owe €489.5 billion through the Target2 system. So it would require at least this much to recapitalise them and clear their debts. To do this, the Italian government would therefore have to raise this money by issuing additional treasury bonds to this amount, which, for want of anyone else with that kind of money, Banca d’Italia would eventually have buy up, printing the necessary euros to do so. This then would add a further €489.5 billion to the Italian national debt, taking it from its current 132% of GDP to 169%, only a little short of that of Greece.

This would have two effects. Firstly, given that Italian treasury bonds are already only rated as Baa3 by Moody’s, it would almost certainly drive them down to a level at which they would be rated as little better than junk, forcing institutional investors – including other NCBs – to sell them and making it almost impossible for the Italian government to raise any further monies on bond markets. Unless the Italian government then immediately balanced its budget by increasing taxes and reducing public expenditure, this would therefore force Banca d’Italia to go on printing euros in perpetuity in order to service the Italian government’s ever-burgeoning debt, thereby raising the question as to whether the euro really was a single currency and whether a euro issued by Banca d’Italia really was the same as a euro issued by the Deutsche Bundesbank.

Indeed, this is a question that is already being asked and is why, in January 2013, the EU required all members of the Eurozone to sign a Fiscal Stability Treaty (FST) that requires all signatories to reduce their debt to GDP ratios to 60% by 2030: something Italy will find it very difficult to do even with its current debt level but which would be absolutely impossible with a debt to GDP ratio of 169%.

This, therefore, leaves the EU with just one other option. In order to recapitalise the Club Med banks and clear their debts in the Target2 system, the creditor nations will, themselves, have to raise the money and gift it to the debtor nations.

Indeed, this is something that has already been suggested by Bob Lyddon, an economist with PwC, who sees it as the most likely solution to the problems he foresees arising out of the Fiscal Stability Treaty itself. In a recent paper entitled ‘Why the Eurozone’s Fate Makes an Immediate Brexit Vital’ he argues that, even at 132% of GDP, Italy’s debt level already makes it more or less impossible for it to achieve its FST target. He calculates that in order to reach a debt to GDP ratio of 60%, Italy would have to run a fiscal surplus of 8.44% for the next ten years, both raising taxes and cutting public spending in order to do so: something he argues would be politically unacceptable to the Italian electorate.

Unwilling to commit political suicide, the Italian government would therefore have no choice but to refuse to comply with the treaty, leaving the EU with just two options. Either it could force Italy out of the Eurozone, upon which it would almost certainly default on its Target2 liabilities, thereby bringing down the entire banking system along with the euro itself; or it could oblige the more solvent EU member states, including Germany, Luxembourg, the Netherlands and Finland to come up with the money to pay down the debts of the Club Med countries for them.

The problem with this, however, is that it would again require around €1 trillion, an amount which the less indebted members of the Eurozone could not raise without making themselves over-indebted, thereby making the situation even worse. Bob Lyddon’s fear, therefore, is that the EU would consequently demand that some of the money – €230 billion, to be exact – be paid by the UK under the ‘contingent liabilities’ clause in Mrs May’s ‘withdrawal agreement’, were this ever ratified. He therefore recommends that the UK make an immediate clean break from the EU, leaving it without any residual treaty obligations. 

While I believe this recommendation to be prudent, however, I do not believe that the impossibility of certain countries achieving their FST targets is what actually constitutes the real danger in all this. This is because I cannot see the other potential contributors to this solution actually being willing to go along with it. After all, according to Lyddon, German tax payers would have to fork out €303 billion to make it work, French tax payers €239 billion. And I just cannot see them accepting this as a price worth paying merely to preserve the single currency. Instead, I believe that the EU will be forced to find some other solution, such as pushing back the date for compliance with the FST to 2050 for instance. After all, this is what the EU typically does when it has an intractable problem: it simply kicks the can down the road for another couple of decades. 

The one instance in which I can see the EU pressing for this wholesale capital transfer solution, however – and, indeed, the member states actually going along with it – is in the event of a catastrophic collapse in the banking system. 

What might trigger this, I cannot say. However, the Eurozone is so fragile and is so full of cracks and vulnerabilities – as I hope that I have already demonstrated – that there are literally dozens of ways in which a cascade failure could be precipitated. And it is at this point, I believe, that the EU would call on the less indebted member states to transfer capital to the more indebted, not in order for the latter to pay down their debts but in order for them to recapitalise their banks. 

The way it would work is like this. The less indebted countries, including Germany, the Netherlands and Finland, would borrow up to €1 trillion from their commercial banks, even though many of these banks might not technically have this money at the beginning of this process. (I shall explain below). They would then gift it to the likes of Italy and Spain which would use it recapitalise their insolvent banks. These banks would then write off their NPLs and discharge their Target2 liabilities to their countries’ NCBs, which would then pay off their debts to their counterparty NCBs. These counterparty NCBs would then be able to discharge their liabilities to their own commercial banks, thereby providing these banks with the necessary funds to lend them to their governments so that they can be gifted to the recipient governments in the first place. This, of course, makes whole series of transactions circular and would mean that it would all need to happen instantaneously. But where banks and money are concerned, almost nothing is impossible.

The result would be threefold: the insolvent banks of the Club Med countries would recapitalised; the unsettled balances in the Target2 system would be cleared; and banks like Deutschebank would now be owed money by their national governments instead of their NCBs. As these latter debts would now be in the form of treasury bonds, however, they could be legitimately bought up by the relevant NCBs under a renewed QE programme, thereby restoring liquidity to the lending banks.

The only losers in all this would therefore be the taxpayers of the gifting countries, whose governments would have accrued an additional €1 trillion in combined national debt, thereby very probably forcing them to put up taxes and cut public expenditure. If they actually understood this and had any say in the matter, these taxpayers would therefore almost certainly demand that the EU immediately start dismantling the Eurozone in an orderly fashion in order to prevent the whole thing happening again. In the current state of our politics, however, the sad truth is that taxpayers have no such voice and, in the above scenario, would almost certainly be prevented from having any idea as to what was going on. In the mainstream media, indeed, the problem, if it were discussed at all, would almost certainly be blamed on a few greedy, ‘fat-cat’ bankers, while prominent Europhile politicians and EU bureaucrats would very likely be credited with saving the system they nearly destroyed.

At no point, of course, would any blame be attached to the euro, which is the one thing the European establishment cannot allow to fail. For without the single currency, there can be no prospect of the EU ever becoming the single European super-state, thereby bringing the entire European Project, as it is currently conceived, to an end. And no one in the EU is as yet willing to let this happen.

So does this mean that the euro can actually be saved? I’m afraid not. It just means that the EU will go on trying to keep alive… until it can’t, and that when it eventually does collapse, as it inevitably will, it will have even more appalling consequences than if its dismantlement had happened in a more orderly way. For in any battle between political ideology and reality, reality always eventually wins, usually at the cost of much human suffering. And that is what I fear the inevitable demise of the euro has in store for us.